Monday, July 31, 2006

Forecasting and Science Fiction 2

A quick note--I should have mentioned Isaac Asimov'sFoundation Trilogy. This is a trilogy that deals specifically with forecasting. The "psycho-historians" anticipated with utmost precision the slow decline of the galactic empire. To arrest this decline, they set up a "foundation" that over time grew into the power vacuum of the empire, reducing the amount of barbarism and destructive warfare, as well as preserving and developing technology.

The psycho-historians have an ability that forecasters today lack, which was they are able to predict when technological advances would happen (and what they'd be). This makes it possible for them to predict 1000 years of future history. (This seems like an appropriate fantasy for a science fiction writer.)

But once they set up the Foundation, they don’t give its members any of the tools of psycho-history. Indeed, Asimov recognized one of the paradoxes of forecasting, which is that if people know the forecast, they will act on it to their advantage, and thus change the future. Asimov has a secret Second Foundation that is constantly developing the science and tweaking human events to better ease the transition away from Empire.

This problem of knowledge of the future affecting the future is one of the key insights of efficient market theory. There have always been persons with systems for beating the market, and some specific investors--Peter Lynch and Warren Buffett, for example--have long records of successfully outguessing the market, identifying bargains. But an efficient market theorist claims this is mostly accidental. It's as if Peter Lynch picked winning horses for 30 years in a row.

But one can understand why this seems like it must logically be true. If you were a technical trader who had a system that actually worked, once other investors discovered the system (presumably by closely observing your investing habits), they would start using it and your advantage would be lost. This is what an efficient market theorist means when he or she says that the market price reflects all the current information out there--it includes all the analyst research and every system currently in use. The market quickly reacts to new "information" (whether that information is information about companies or the economy, or if it's information about the trading price of a security) and there is always a reversion to a mean price.

In the Foundation Trilogy, the one thing that isn't anticipated is the emergence of a psychic person, able to influence great numbers of persons with his mind. He therefore defies the laws of large numbers that make statistics work. In the real world, this is the problem with technological change and random events. An economist may be able to build a reasonable model of an economy, but a single unpredictable event like a massive tsunami or the discovery of oil will throw a big monkey wrench in the work. Still, one can at least build the possibility of a tsunami or oil strike into one's model because these things have happened before. But no one can anticipate, say, the discovery of some new, hitherto undreamed-of technology.